Euro area annual HICP inflation was 2.6% in March 2011, according to Eurostat’s flash estimate, after 2.4 % in February. The increase in inflation rates in early 2011 largely reflects higher commodity prices. Pressure stemming from the sharp increases in energy and food prices is also discernible in the earlier stages of the production process. It is of paramount importance that the rise in HICP inflation does not lead to second-round effects in price and wage-setting behaviour and thereby give rise to broad-based inflationary pressures over the medium term. Inflation expectations must remain firmly anchored in line with the Governing Council’s aim of maintaining inflation rates below, but close to, 2% over the medium term.

That is, the recent blip in inflation is largely due to energy prices, but the worry is that this will lead to higher wage demands and ultimately more general price increases. This would be particularly bad if people began to make plans based on expectations of higher inflation (i.e., expectations became un-‘anchored’). Those worries are ill-founded, says Paul Krugman:

Overall eurozone numbers look very much like US numbers: a blip in headline inflation due to commodity prices, but low core inflation, and no sign of a wage-price spiral. So the same arguments for continuing easy money at the Fed apply to the ECB. And the ECB is not making sense: it’s raising rates even as its official acknowledge that the rise in headline inflation is likely to be temporary.

Former Fed governor Larry Meyer had a nice op-ed on the subject in the Times last month.Inflation targeting and ‘credibility.’ A temporary energy-price driven inflation spike may be harder for an inflation-targeting central bank like ECB to brush off. The goal of inflation targeting is to make monetary policy credible – i.e., to keep inflation expectations anchored – but it only works if the announced target is met. Gavyn Davies writes:

Of course, when an adverse supply shock hits the economy, there are no easy paths for the central bank to adopt, and the ECB will protest that its mandate requires it to hit its CPI inflation target regardless of the consequences for GDP growth. But it can expect no praise if it pushes the economy back into recession.

The optimum currency area problem. Or, really, the problem that the euro zone isnt one. The single currency means a single monetary policy. That works if the economies of Europe move together, but they arent. This map of unemployment rates across Europe illustrates the problem:

The lightest yellow shade are countries with unemployment rates below 7% and the darkest red have rates above 13%, including 14.9% in Ireland and 20.5% in Spain. (A small irony: Eurostat’s nifty map tool makes it very easy to illustrate the fundamental flaw of the euro project). In the high unemployment countries, it is hard to imagine that workers would be in a strong position to demand higher wages to make up for the increase in energy prices. But Trichets worry may make more sense in the parts of Europe where labor markets are tighter. And Trichet can only make one monetary policy. As Floyd Norris puts it:

‘If you take the euro area as a whole . . .’So began a response Thursday from Jean-Claude Trichet, the president of the European Central Bank, as he explained the central bank’s decision to raise interest rates in Europe.If only there were a ‘euro area as a whole.’

[T]his move may have begun the countdown to the Eurozone breakup. It is hard to see how else this can turn out. The Germans–the folks who really call the shots in Europe–are reluctant to see the needed debt restructuring in the periphery and are equally reluctant to provide bailouts large enough to fix the problem. So far the Germans have been kicking the can down the road on these issues. With ECB monetary policy now tightening they will soon run out of road to kick the can down.

One irony here is that many of the same sorts of people who have taken to criticizing the Fed for ‘printing money’ are also prone fretting that America is sliding down the slippery slope to ‘European socialism’ (trains and universal healthcare – quelle horreur!). Next time Ron Paul says we need to return to ‘sound money’, someone needs to tell him to move to Europe!